Islamic finance refers to the means by which corporations in the Muslim world, including banks and other lending institutions, raise capital in accordance with Sharia, or Islamic law. It also refers to the types of investments that are permissible under this form of law. A unique form of socially responsible investment, Islam makes no division between the spiritual and the secular, hence its reach into the domain of financial matters. Because this sub-branch of finance is a burgeoning field, in this article we will offer an overview to serve as the basis of knowledge or for further study.
The Big Picture
Although they have been mandated since the beginnings of Islam in the seventh century, Islamic banking and finance have been formalized gradually since the late 1960s, coincident with and in response to tremendous oil wealth which, fueled renewed interest in and demand for Sharia-compliant products and practice.
Central to Islamic banking and finance is an understanding of the importance of risk sharing as part of raising capital and the avoidance of riba (usury) and gharar (risk or uncertainty). (To see more on risk, read Determining Risk And The Risk Pyramid and Personalizing Risk Tolerance.)
Islamic law views lending with interest payments as a relationship that favors the lender, who charges interest at the expense of the borrower. Because Islamic law views money as a measuring tool for value and not an 'asset' in itself, it requires that one should not be able to receive income from money (for example, interest or anything that has the genus of money) alone. Deemed riba (literally an increase or growth), such practice is proscribed under Islamic law (haram, which means prohibited) as it is considered usurious and exploitative. By contrast, Islamic banking exists to further the socio-economic goals of Islam.
Accordingly, Sharia-compliant finance (halal, which means permitted) consists of profit banking in which the financial institution shares in the profit and loss of the enterprise that it underwrites. Of equal importance is the concept of gharar. Defined as risk or uncertainty, in a financial context it refers to the sale of items whose existence is not certain. Examples of gharar would be forms of insurance, such as the purchase of premiums to insure against something that may or may not occur or derivatives used to hedge against possible outcomes. (To read more about insurance or hedges, see A Beginner's Guide To Hedging, Understand Your Insurance Contract and Exploring Advanced Insurance Contract Fundamentals.)
The equity financing of companies is permissible, as long as those companies are not engaged in restricted types of business - such as the production of alcohol, pornography or weaponry - and only certain financial ratios meet specified guidelines.
Basic Financing Arrangements
Below is a brief overview of permissible financing arrangements often encountered in Islamic finance:
- Profit-and-loss sharing contracts (mudarabah). The Islamic bank pools investors' money and assumes a share of the profits and losses. This is agreed upon with the depositors. What does the bank invest in? A group of mutual funds screened for Sharia compliance has arisen. The filter parses company balance sheets to determine whether any sources of income to the corporation are prohibited (for example, if the company is holding too much debt) or if the company is engaged in prohibited lines of business. In addition to actively managed mutual funds, passive ones exist as well based on such indexes as the Dow Jones Islamic Market Index and the FTSE Global Islamic Index. (To find out more about reading company balance sheets to determine debt, see Reading The Balance Sheet, Breaking Down The Balance Sheet and Uncovering Hidden Debt.)
- Partnership and joint stock ownership (musharakah). Three such structures are most common:
a. Declining-Balance Shared Equity: Commonly used to finance a home purchase, the declining balance method calls for the bank and the investor to purchase the home jointly, with the institutional investor gradually transferring its portion of the equity in the home to the individual homeowner, whose payments constitute the homeowner's equity.
b. Lease-to-Own: This arrangement is similar to the declining balance one described above, except that the financial institution puts up most, if not all, of the money for the house and agrees on arrangements with the homeowner to sell the house to him at the end of a fixed term. A portion of every payment goes toward the lease and the balance toward the purchase price of the home.
c. Installment (Cost-Plus) Sale (murabaha): This is an action where an intermediary buys the home with free and clear title to it. The intermediary investor then agrees on a sale price with the prospective buyer; this price includes some profit. The purchase may be made outright (lump sum) or through a series of deferred (installment) payments. This credit sale is an acceptable form of finance and is not to be confused with an interest-bearing loan.
- Leasing ('ijarah/'ijar): The sale of the right to use an object (usufruct) for a specific time period. One condition is that the lessor must own the leased object for the duration of the lease. A variation on the lease, 'ijarah wa 'iqtina provides for a lease to be written whereby the lessor agrees to sell the leased object at the lease's end at a predetermined residual value. Only the lessor is bound by this promise. The lessee, by contrast, is not obligated to purchasing the item.
- Islamic Forwards (salam and 'istisna): These are rare forms of financing, used for certain types of business. These are an exception to gharar. The price for the item is prepaid and the item is delivered at a definite point in the future. Because there is a host of conditions to be met to render such contracts valid, the help of an Islamic legal advisor is usually required.
Basic Investment Vehicles
Here are some permissible types of investment for Islamic investing:
- Equities. Sharia law allows investment in company shares (common stock) as long as those companies do not engage in lending, gambling or the production of alcohol, tobacco, weaponry or pornography. Investment in companies may be in shares or by direct investment (private equity). Islamic scholars have made some concessions on permissible companies, as most use debt either to address liquidity shortages (they borrow) or to invest excess cash (interest-bearing instruments). One set of filters excludes companies that hold interest-bearing debt, receive interest or other impure income or trade debts for more than their face values. A further distillation of the aforementioned screens would exclude companies whose debt/total asset ratio equals or exceeds 33%; companies with "impure plus non-operating interest income" revenue equal to or greater than 5% or companies whose accounts receivable/total assets equal or exceed 45% or more.
- Retirement Investments. Retirees who want their investments to comply with the tenets of Islam face a dilemma in that fixed-income investments include riba, which is forbidden. Therefore, specific types of investment in real estate, either directly or in securitized fashion (a diversified real estate fund), could provide steady retirement income while not running afoul of Sharia law.
- Sukuk. In a typical ijara sukuk (leasing bond-equivalent), the issuer will sell the financial certificate to an investor group, who will own them before renting them back to the issuer in exchange for a predetermined rental return. Like the interest rate on a conventional bond, the rental return may be a fixed or floating rate pegged to a benchmark, such as LIBOR. The issuer makes a binding promise to buy back the bonds at a future date at par value. Special purpose vehicles (SPV) are often set up to act as intermediaries in the transaction. A sukuk may be a new borrowing, or it may be the Sharia-compliant replacement of a conventional bond issue. The issue may even enjoy liquidity through listing on local, regional or global exchanges according to an article in CFA Magazine titled "Islamic Finance: How New Practitioners of Islamic Finance are Mixing Theology and Modern Investment Theory" (2005).
Basic Insurance Vehicles
Traditional insurance is not permitted as a means of risk management in Islamic law. This is because it constitutes the purchase of something with an uncertain outcome (form of ghirar), and because insurers use fixed income - a form of riba - as part of their portfolio management process to satisfy liabilities.
A possible Sharia-compliant alternative is cooperative (mutual) insurance. Subscribers contribute to a pool of funds, which are invested in a Sharia-compliant manner. Funds are withdrawn from the pool to satisfy claims, and unclaimed profits are distributed among policy holders. Such a structure exists infrequently, so Muslims may avail themselves of existing insurance vehicles if needed or required.
Islamic finance is a centuries-old practice that is gaining recognition throughout the world and whose ethical nature is even drawing the interest of non-Muslims. Given the increased wealth in Muslim nations, expect this field to undergo an even more rapid evolution as it continues to address the challenges of reconciling the disparate worlds of theology and modern portfolio theory.
To read more on this subject, see What is an Islamic investment policy?
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